Fundamental Analysis is a stock valuation methodology of evaluating securities intrinsic value by examining related economic, financial and other qualitative and quantitative factors. The fundamental data that is analysed not only takes into account the financial information of the company, but also the non-financial information forms a part. The non-financial information includes growth estimates, demand for products, industry comparisons, economy-wide changes, changes in government policies, etc.
While making an investment the investor needs to know the viability of its investment and needs to know if the current price charged per unit is justified by the results the company has delivered recently, and also whether it has or not the potential to deliver gains in the future. The return on investment is the primary concern of any investor. Through Fundamental Analysis, an investor seeks to derive value, which when compared with the price of the security will help to make a decision whether the security should be bought or sold depending on whether its underpriced or overpriced. (underpriced = buy, overpriced = sell or short).
Fundamental analysis- a process
Fundamental analysis consists of a systematic series of steps to examine, these are:
- Macroeconomic analysis: This involves analysing capital flows, interest rate cycles, currencies, commodities, indices, etc.
- Industry analysis: This involves the analysis of the industry, and the companies that are a part of the sector.
- Situational analysis of the company.
- Financial analysis of the company.
Fundamental tools to identify right stock
Fundamentals are all about earnings, and the bottom line is what the investors are concerned about. The demand for any security depends on the earnings generated. With the rise in earning the demand for the stock goes up, which further leads to a higher stock price. It might also bring a regular dividend flow along.
Some of the most popular tools of fundamental analysis focusing on earnings, growth and value, are discussed below:
Earnings per share also known as EPS is a major criterion used for the price determination of any share. Price-to-earning valuation ratio is determined using the EPS. On comparing the EPS of two companies of the same industry a valuable insight can be gained, but EPS alone is not sufficient to judge the market position of the stock. EPS just gives a glimpse of the company’s efficiency, but do not frame out the whole picture of the company alone. So, investing in a company with high EPS is good, but solely on this metric is an unsound decision.
Price-to-Earnings ratio is one of the best-known fundamental ratios as it provides a measuring stick to compare valuations across the companies. Companies with moderate and consistent P/E ratio are considered to be the right stock. The price of a share when divided by its EPS gives the P/E ratio, which informs the amount an investor is willing to pay for each dollar of a company’s earnings.
Debt-Equity ratio measures the proportion of financing a company received from debt (like loans or bonds) and equity (like the issuance of stock). Having an adequate level of debt and equity makes the company more sound and capable, but a desirable debt-equity ratio varies from industry to industry.
Free Cash Flow is one of the better ways to analyze the liquidity position of the company. Free cash flow helps an investor to know how much actual cash a company is left (to pursue future endeavours) with after capital investments. Investing in a company with high liquidity is a good decision.
Going beyond numbers
When it comes to investing, the numbers aren’t everything. There are qualitative metrics – like management quality – that also affect the company’s valuation. So, trusting only the quantitative aspects every time is not a good decision to make.
Lot many factors, other than the EPS and P/E ratio, play an important role in making investment decisions. The companies that hold the top positions in their respective industries are the ones that are often the best performers on the stock market. Your goal should be to identify the present-day leaders, potential leaders and the companies having the best financials in their respective areas.
Word of caution
Generally it has been seen that in the long-run securities reflect the true fundamental value, but in the short-run, the stocks might ignore the fundamentals and move in an opposite direction owing to a number of factors like macro scenario, investors emotions, etc.
While the statements and press releases by the firms are good sources of information, but they are a mix of facts and educated guesses based on those facts. Hence, it is always advisable to move ahead with caution before initiating any position. It is very important for an investor to be able to use his/her discretion while going through such reports. Investors should be wise enough to use the important information and be able to disregard the hype created.